Abenomics’ Third Arrow Spurs Dan Loeb and Others to Shake Up Japan

For decades Japan Inc. has frustrated the efforts of just
about every foreign shareholder activist who has tried to storm
its gates. Beginning with T. Boone Pickenss 1989 bid to
get seats on the board of Koito Manufacturing Co., a Toyota
parts supplier, Japanese companies have relied on insider board
directors and passive domestic investors to block
activists attempts to gain influence over strategy or
increase dividend payouts.

Today, however, activists are enjoying unprecedented
success. And they are doing so by wrapping themselves in the
Japanese flag  and the corporate governance reforms of
Prime Minister
Shinzo Abe  to campaign for change.

Take
Dan Loeb. In his October 2015 quarterly letter to
investors, the founder and CEO of
Third Point announced that the hedge fund firm had taken a
stake in Seven & i Holdings Co. in what he proclaimed to be
one of the most crucial tests for the success of
corporate governance reform in Japan.

Paying little mind to shareholder returns over the years,
the company  Japans largest retailer and the
operator of the countrys 7-Eleven convenience store chain
 had propped up lossmaking businesses, paid miserly
dividends and never considered
share buybacks. In years past, Seven & i could have
simply swatted Loeb aside as a foreign interloper willing to
damage a Japanese institution for short-term gain. But since
Abe embraced greater shareholder involvement as part of his
so-called
third arrow of corporate governance reforms, investors like
Loeb have gained real clout.

Loeb has been campaigning for greater shareholder returns in
Japan since 2013 and has taken stakes in robot maker Fanuc
Corp., Suzuki Motor Corp., construction and machinery giant IHI
Corp. and Sony Corp., the electronics and entertainment
company. We effectively give them a dare-to-be-great
speech that connects them to the principles around governance
that their own government has articulated as part of the third
arrow strategy, Loeb tells Institutional
Investor. Its subtle, but I think its
more palatable because the companies dont have to do
something that an outsider wants them to do; they are following
the leadership of their own government.

Abes reforms include a new corporate governance code
adopted last year that urges businesses to boost their return
on equity to more than 8 percent. They also require companies
listed on the Tokyo Stock Exchanges first and second
sections  the countrys large and medium-size
businesses  to have at least two independent directors.
The measures aim to drive greater corporate discipline and prod
boards to show more concern for shareholders.

Since the code took effect, nearly all large-cap companies
in Japan have appointed two, or more, outside directors;
however, the caliber of those outsiders  few of them
foreigners  leaves many investors unimpressed. A March report by Jefferies Group concluded
that fewer than 10 percent of companies in the Topix 500 index
had an acceptable board structure and only 1 percent could be
considered good. Seven & i, for instance, boasts four
outside directors, but the report scored it worst of all in
terms of skills and expertise. All the outside directors
come from academia or are retired bureaucrats, which is a
negative, says Zuhair Khan, the lead analyst on the
report.

Even so, Third Point found an ally in Kunio Ito, a professor
at Hitotsubashi University who was appointed to Seven &
is board in 2014 after heading an advisory committee
whose recommendations laid the groundwork for Japans
corporate governance reforms. When rumors circulated earlier
this year that the companys 83-year-old CEO, Toshifumi
Suzuki, was trying to oust the president of its most successful
business unit, 7-Eleven Japan, to clear a succession path for
his son, Loeb sent an open letter  anathema in Japan
 to the board invoking the corporate governance code.
Our goals are fully consistent with the Third Arrow of
Abenomics: a focus on shareholder interests and returns, and
engagement in forward-looking corporate governance that should
make Japanese companies more competitive and attractive
investment opportunities, he wrote.

The call to arms resonated with Ito, who succeeded in
killing the April 7 vote to fire the 7-Eleven Japan president,
Ryuichi Isaka. Suzuki resigned as CEO hours later.
Corporate governance finally started working at the
firm, says one shareholder, who asked to remain
anonymous. I dont deny Mr. Suzukis tremendous
achievement but always felt no one would dare say no to
him.

It was a rare victory for an activist hedge fund, and one
that was lionized ­rather than demonized in the Japanese
media as the dawn of a new era in corporate governance.
If they follow the path that we laid out, and the one I
think theyre pursuing, Seven & i is an example of a
Japanese company that will really prosper in this challenging
economic environment, says Loeb. Seven & is
share price rose 7.2 percent in the week following
Suzukis resignation but has since fallen by 12.8
percent.

Japanese companies and their domestic investors have
traditionally frowned on shareholder activism. In the 1980s
buying shares in a company in order to disrupt annual general
meetings or blackmail executives became a common tactic of
extortionists, called sokaiya, who typically had ties
to yakuza organized crime syndicates.

Although a law enforcement crackdown effectively stopped the
practice by the early 2000s, Japanese executives cited the
example of past shakedown attempts to shun activists when a
fresh batch of barbarians gathered at the gates. From 2003 to
2010 the brash New York hedge fund firm Steel Partners, led by
Warren Lichtenstein, tried to take over a series of Japanese
businesses, including Sapporo Breweries, only to be thwarted by
poison pills and a hostile press.

Today, however, Japan is starting to change its tune. As
part of the third arrow, Abe has called on institutions to
become more actively involved in the companies in which they
invest. More than 100 money managers and asset owners agreed to
make their voices heard when they signed Japans
stewardship code, Principles for Responsible
Institutional Investors, in 2014.

The code has created an atmosphere that welcomes
dialogue between investors and corporates, says Akitsugu
Era, the head of investment stewardship for BlackRock Japan.
Since its launch the number of companies that BlackRock
can access has grown exponentially. In the first half of 2016,
Eras team met with 150 businesses, equal to the total
number of meetings in 2015 and about three times more than in
prior years.

As investors become more discerning, activists may find it
easier to win support for their proposals. For the fiscal year
ended March 2016, Japans 3,600 publicly traded companies
paid a record 11 trillion yen ($107 billion) in dividends. They
also bought back 5.3 trillion yen worth of shares, up 60
percent from a year earlier.

Activists targeted 13 Japanese companies in the first seven
months of this year, up from eight in all of 2015, according to
London-based data provider Activist Insight. Not everyone has
been as successful as Loeb. When The Childrens Investment
Fund Management took a 1.4 percent stake in Japan Tobacco in
2011 and began demanding that the state-controlled company
boost its payout ratio, exit unprofitable businesses and buy
back stock from the government, other shareholders gave it the
cold shoulder.
Chris Hohn, founder and managing partner of the
London-based hedge fund firm, and Oscar Veldhuijzen, a partner
responsible for the investment, raised their proposals at the
companys annual general meeting for four straight years
even though off-agenda questions were against the rules. The
tactics didnt win many friends; TCI lost every proxy
fight even after the government reduced its stake from 50
percent to 33 percent in 2013 to raise money for reconstruction
following the Tohoku earthquake and tsunami of 2011.
TCIs proposal and activist style is still too
extreme, too antagonistic to work in Japan, and actually might
risk defensive response from the management rather than
constructive change, says one buy-side analyst.

Japan Tobacco eventually adopted many of TCIs ideas,
albeit at a slower pace and smaller scale than the firm would
have liked  and not because of shareholder pressure, a
spokesman insists. In theory we wouldve been able
to force managements hand at that point with help from
other shareholders, says Veldhuijzen. But Japanese
shareholders always voted in line with the recommendations from
management.

Other activists have adopted a less confrontational
approach. Alexander Roepers, founder and CIO of $1.3 billion
Atlantic Investment Management, recalls that during his first
visits to Japan, in 2004, he had to explain in every meeting
with company managements that his New Yorkbased firm was
not a copycat of Steel Partners or other American activists.
In many cases they hadnt done their homework or
were barking up a tree that would never move, Roepers
says, referring to other activists. At the end of the
day, were value investors who are rolling up our sleeves
and working with management to improve things for everybody,
and I think thats the only way that works.

Atlantic opened a Tokyo office in 2006 and now has four
employees there. Over the past three years, Roeperss team
was invited to meet with senior advisers to Abe to consult on
the new corporate governance code. Todays activists
have a corporate governance code to shake a stick at,
which is a sea change, says Nicholas Benes, co-founder of
the Board Director Training Institute of Japan, who also
consulted for the Abe administration on the code. Before,
if you talked about shareholder value and raising your earnings
and ROE [return on equity], people could label you an activist
with a big 'A' on your forehead, and then youre a bad
guy.

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